How Low Can We Go?

• AFRM (Donny): Fresh off a big win in OKLO the week before, we nailed our AFRM entry in the week leading up to its Q4 earnings release. Gained entry at $57 with the stock now at $78 (36% unlevered return in 2 weeks, including 21% on earnings release date).

• TAO (Crypto Fox): Telegram limit long bid at 393$ hit 437$ for an 11.22% unleveraged move to the upside - 4.2R (sl being 382.5$)

Last week, we discussed the concept of Global Liquidity. If you haven’t read it yet, we recommend reading it HERE.

In this episode, we’ll review how the Fed works and how macro events tie into the market.

Understanding The Fed

The Fed or Federal Reserve is the U.S. Central Bank. Their job is to “manage” the economy.

The FED works with what they call a ‘Dual Mandate.’ They want to keep inflation “low” around 2% while at the same time maintaining unemployment low (i.e., everyone has a job).

They achieve this through a few primary tools. Let’s discuss those tools and how they affect our lovely asset markets.

1. Fed Funds Rate
   The Fed sets the interest rate on bank loans. While the entire system is highly convoluted, the effect can simply be described as making money expensive by raising rates or cheap by lowering them.
   

   • When interest rates are low, money flows easily, stimulating economic activity. During periods of low rates, many companies borrow and push for growth. This boosts profits, helps companies expand, and, most notably for the Fed, results in hiring.
     
     In other words, lower unemployment means more people with jobs. However, aggressive spending and easy money can also cause inflation.
     

   • When they raise interest rates, they are intentionally slowing economic activity. Borrowing is more expensive, it’s harder to get cheap money, and companies and consumers tend to be more frugal during these periods.
     
     After all, if you can’t pay your debts, you go under. As a result, you’ll often see layoffs during periods of high interest rates. This is reflected in the tech sector (a high growth sector) where tens-of-thousands of people got laid off.
     
     So why do it? To control inflation. Slowing the economy will encourage people to spend less. When people spend less, companies cannot sell or charge as much, and when companies don’t make much money, their suppliers do less, too. It trickles down, and people stop raising prices. (In theory, of course)
     

2. Quantitative Easing/Tightening

   
   Another way the Fed can stimulate or slow down the economy is through QE or QT.
   
   During Quantitative Easing, the Fed buys assets, lowers rates, and uses everything on its toolbelt to inject liquidity into the economy.
   
   This boost in liquidity can result in amazing rallies in crypto and markets. QE fueled the 2020-2021 bull run, so everything went crazy.
   
   However, by November 2021, the Fed had started Quantitative Tightening, essentially the opposite of QE. This policy effectively reduced liquidity conditions, nuking asset markets.
   

3. Forward Guidance
   The goofiest of their tools is their Forward Guidance. By telling the world what they plan to do ahead, investors, traders, and companies will make financial decisions based on those plans.
   
   So, when they want things to slow down, rather than immediately raising rates, they might tell the world, “We’re raising rates by this much over this period.”
   
   This has resulted in the entire U.S. Stock market and crypto swinging everywhere when some old man speaks.
   

Relevance

What do we, as investors/traders, need to know? It’s simple: If the Fed says it will actively raise rates or start QT, we want to be more risk-off.

When the Fed says they’ll cut rates and perform QE, we want to be risk-on.

While we can sit here and worry about every FOMC meeting and every CPI / Unemployment report, we must focus on the big picture. Will this increase or decrease liquidity conditions?

So, where do Inflation & Unemployment come in? Why do people care?

1. Inflation Rate (CPI / PCE / PPI)
   A few measures track the Inflation rate, but here’s what you need to know.
   
   Most people will hear about the ‘Headline Inflation’ number. It is simply a measure of how much more expensive prices are this month compared to the same prices a year ago.
   
   Note: A common misconception is that inflation going down means things are becoming cheaper. This is not the case. Inflation measures the ‘rate of change’. Prices are still going up, just not as fast.
   
   “The damage has already been done, but don’t worry; future damage will happen more slowly.”
   
   So why should any investor or trader care about the inflation rate? Some investors look to the inflation rate to better judge what the Fed will do next. If inflation is out of control, they’re more likely to raise rates to slow inflation. (And in doing so, lower liquidity. 

   Knowing the intricacies of each type of inflation measure is relatively pointless as a trader. It is only relevant to understand what actions the Fed might take.
   

2. Unemployment
   Unemployment is just a measure of the number of people unemployed. Recessions occur when the rate gets too high and everyone loses their jobs. The Fed would like to avoid that.

If it gets out of control, the Fed will likely take action and stimulate the economy, which will benefit our markets. 

Regarding macro news, focus on the big picture, don’t worry too much about timing, and remember that the market’s reaction is much more important than the specific number.

If the chart is bullish, even with weak macro data, we follow it. However, a major shift in the Fed’s policy can be an early signal that things could change significantly.

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